Five points on tax reform

Earlier this year, we released an article which discussed the need for a better vision for Australia’s tax system. The government is already taking this approach in Superannuation reform, following recommendation from the Financial Systems Inquiry. The Murray Inquiry recommended that legislation be developed to enshrine the objective of the superannuation system, in order to provide a framework for “important discussions Australia needs to have about fairness, adequacy and dignity in the superannuation system”.

Just as with super, any debate on tax policy reform should be preceded by a discussion on the purpose of the tax system.

At a high level, this is pretty well agreed upon – the tax system raises the funds necessary to finance public services like health, education, infrastructure and national defence, as well as providing a social safety net. From an economic perspective, it effectively transfers a portion of economic activity from households to government, to deliver services or redistribute to other households. This process also creates some distortions in the market, which have a cost to the overall economy.

The call for tax reform indicate that the tax system is, at some level, failing to achieve this purpose.

Currently, the government collects taxes of 23.5% of GDP from the economy, and then redistributes 26% of GDP as public services or wealth transfers. The 2.5 percentage point gap is largely financed by borrowings, and is providing much of the impetus for reform. Other parties are arguing that the tax system itself is inefficient, and is imposing too high a cost on the economy.

There may then be more than just a single aim of tax reform. Some proposed reforms have been aimed at addressing the funding gap. Other reforms are aimed at improving the efficiency or effectiveness of the overall tax system, to limit the negative economic impacts of transferring money from households to government and then back again. Any comprehensive tax reform package would ideally reflect both of these aims.

The tax reform discussion is only just getting started, and is sure to become more pointed as proposed reforms take shape and more vested interests contribute to the debate. Here are five points on tax reform to keep in mind for the future:

Five points on tax reform

1. Fiddling with tax rates is not tax reform

Changes to individual tax rates are unlikely to create any meaningful impact on the overall efficiency or effectiveness of the tax system. In addition, changes to the amount of tax that is collected is often justified on political rather than economic grounds, and based on partisan beliefs about the appropriate role or size of government.

2. Lowering taxes on businesses is not ‘unfair’

As corporations are just legal constructs, tax paid by businesses must eventually be borne by individuals. When a corporation pays tax, either shareholders receive lower returns, consumers pay higher prices, or workers receive lower wages. Most literature supports that in small, open economies like Australia’s, it is workers who bear most of the burden of corporate taxes. As a result, lowering corporate taxes shouldn’t be seen as favourable treatment for the wealthy.

3. Broader tax bases and lower tax rates are better for the economy

Generally, a tax is efficient where it minimises distortions to production and consumption decisions. For example, until recently the GST did not apply to imports under $1000. This made goods purchased from international retailers relatively cheaper, and provided an incentive for consumers to buy goods from overseas instead of Australia – even though that might involve shipping a similar item halfway around the world. Taxes with a narrow base and a high rate exacerbate this effect, changing the behaviour of individuals away from their original intentions. Across the whole economy, these inefficiencies add up to a major cost.

4. The income tax system is overgrown

Even after the removal of 4,100 pages of ‘inoperative provisions’ in 2006, The Income Tax Assessment Act 1997 extends overs 11 volumes and 5,095 pages. The 2006 measures revolved around drafting changes rather than any substantial policy simplification, leaving significant scope to further reduce complexity in the system. True income tax reform should go further than tinkering with indexation or tax brackets

5. The tax system is overused as a policy instrument

Almost every tax inquiry since the 1975 Asprey Review has come to the same conclusion: Australia has too many taxes and too many complicated ways of delivering multiple policy objectives through the tax and transfer systems. The Henry Review went further in 2010, noting that the tax and transfer architecture is beginning to fail in dealing efficiently and effectively with multiplying policy goals and demands.